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As we approach 2022 and the momentum behind decarbonization and net-zero objectives builds around the world, asset owners are increasingly engaged in addressing the investment implications of climate change. The focus thus far has largely been on implementation at the security- and manager-selection levels, but there is a growing recognition of the need to factor climate change into broader investment policy and asset allocation decisions.
Our Investment Strategy Team, in partnership with our Climate and ESG teams, has developed a framework for integrating climate change and its capital-market effects into multi-asset portfolios. We had a simple but important philosophical starting point for this work: We believe climate change impacts investment outcomes. It impacts macro-level variables, such as GDP growth and inflation; company-level dynamics, such as costs and future company activity; and decisions about regulation and fiscal policy. These, in turn, all impact asset prices.
The complexity of climate change and its effects requires a clear framework for systematically organizing, researching, and integrating climate change in multi-asset portfolios. Ours consists of three pillars:
We generate long-term return, risk, and correlation metrics (collectively referred to as our capital market assumptions or CMAs) to underpin our strategic asset allocation decisions. These proprietary metrics include numerous inputs, such as economic growth and corporate earnings, each of which, to our earlier point, will be affected by climate change.
To incorporate climate change into our 10-year CMAs, we’ve focused on two areas of climate-related risk — transition risk and physical risk — and their relevance to our CMA inputs (Figure 1). Transition risk concerns the impact of policy/regulatory changes (carbon pricing, subsidies, etc.), technological disruption (the move to renewables), and market behavior/societal pressures. Physical risk concerns changes to the physical environment brought on by climate change, including chronic risks (long-term shifts in climate patterns) and acute risks (e.g., the increased severity of drought or wildfire).
Given the complexity of the data and assumptions required for transition and physical risk research, we are taking two distinct approaches: For the estimation of transition risk and chronic physical risk, we are using the second iteration of the scenarios designed by the Network for Greening the Financial System (NGFS), a group of 66 central banks and supervisors. And for the estimation of acute physical risk, we are leaning into our firm’s research partnership with Woodwell Climate Research Center to develop a methodology similar to an expected credit loss calculation. In light of the long-term nature of climate change and the 10-year horizon of our CMAs, we expect transition risk to have a greater impact than physical risk. We plan to introduce our climate-aware CMAs and our findings in early 2022.
This pillar is focused on adding relevant climate metrics to the other metrics we include in our asset allocation optimization process. By quantifying the carbon intensity of the various potential allocations, for example, we can undertake analysis around climate exposure similar to our approach to other risk exposures. In particular, we can understand the exposure of each asset allocation, identify the optimal climate-aware portfolio for a given return, and target a carbon emission level on a relative (versus a reference benchmark) or absolute (emission constraint) basis.
While our research in this area is ongoing, we can generally take one of two approaches. The first incorporates specific climate guidelines (e.g., restrictions on the carbon intensity of an allocation) into the optimization process. This approach is scalable and makes climate considerations an inherent part of the asset allocation process. Alternatively, exposures can be tilted after the optimization process is conducted, based on climate priorities — an approach that is more flexible and allows for very deliberate decisions about how to shift exposures.
The third pillar is focused on the impact of using climate-aware strategies to express the asset allocation. For instance, could the use of climate-aware strategies introduce structural biases (sector, style, or factor)? And could the pursuit of specific outcomes (e.g., defensiveness or income in an equity portfolio) be affected by the simultaneous pursuit of climate goals?
Climate-aware strategies include a wide range of approaches, with many of the definitions still in flux. Some strategies, for instance, seek to generate excess returns while being exposed to fewer emissions than their benchmark (e.g., “negative screening” and “ESG integration” strategies). Others seek to generate returns by exploiting changes and opportunities brought about by climate change (e.g., “impact investing” and “thematic” strategies).
Regardless of the approach, members of our Fundamental Factor Team have found that investors should indeed be aware of the potential for structural effects, though these differ across regions and objectives. For example, looking at European equity portfolios, they found that income is generally a space with high relative carbon intensity, and therefore greater carbon constraints were associated with a steadily decreasing yield. In terms of structural biases, the team found that as carbon constraints rose in European income strategies, the portfolios became less overweight value and less underweight growth and quality.
On the other hand, integrating carbon constraints in European defensive portfolios (i.e., portfolios targeting minimum absolute volatility) did not meaningfully limit the opportunity set until the constraints became quite restrictive. And while the impact on biases was minimal until carbon constraints became more aggressive, there was a similar pattern as with income: Greater constraints eventually led to less value exposure and more growth and quality exposure.
Read more on the team’s research here, and watch for a paper on our climate-aware CMAs in the new year.
Climate change investing remains a top priority for the firm for 2022. In response to increasing challenges arising from climate change and growing client interest in climate solutions, we have expanded our climate investing offerings to include late-stage private equity, market-neutral (long/short) strategies, and adaptation-focused equities. Our broadening agenda for 2022 with Woodwell Climate Research Center may include research into biodiversity, forestry, agriculture, and new climate solutions. Finally, we plan to strengthen our efforts related to climate engagement, using our role as an active owner to encourage companies to improve climate reporting and disclosures and establish credible transition plans.
In 2022, we will continue to research the climate investing universe for mitigation- and adaptation-related solutions. The climate opportunity set is rapidly expanding, with technological innovations stemming from both private and public companies. Venture capital should play a key role in supporting the development of climate technologies from private start-ups, while end markets for a range of solutions will continue to grow. We believe demand for products and services that enable decarbonization and adaptation will grow as society appreciates their significance and value. In our view, markets still underestimate both the negative effects of climate change and the significant growth potential for companies addressing these challenges.
The adaptation universe, in particular, is ill defined, often incorrectly categorized as renewable energy. This is, in fact, a broad opportunity set that includes climate solutions for enhanced resilience. Governments, consumers, and companies across many industries — including agriculture, construction, transportation, health care, and utilities — may benefit from adaptive products like air conditioning, backup power, water security, process optimization, flood mitigation, weather analytics, and many more.
The 2021 United Nations Intergovernmental Panel on Climate Change’s (UN IPCC’s) Sixth Assessment Report calls for more adaptation spending in the public and private sectors to protect life, property, and infrastructure from climate variability. The accelerating, irreversible effects of climate change, combined with society’s general lack of preparedness, give us high conviction that the market for adaptation solutions will continue to expand. According to the Global Commission on Climate Adaptation (GCA), the market for adaptation is already enormous and may be much larger than markets realize. The GCA’s research projects that investing US$1.8 trillion in adaptation could generate US$7.1 trillion in net benefits.1
In November 2021, the United Nations Climate Conference of the Parties (COP26) raised awareness about the action required to address climate change. It was a call to arms for governments, companies, and the investment community to develop more coordinated and impactful strategies. Capital market participants played a key role, with many large banks, insurers, and institutional investors pledging to align US$130 trillion in assets with net-zero ambitions, complementing nationally determined contributions (NDCs) communicated at the conference. We are proud to be a part of these efforts as a founding member of the Net Zero Asset Managers initiative (NZAMI) and a member of the newly formed Glasgow Financial Alliance for Net Zero (GFANZ).
We support the conference’s focus on forestry preservation and reducing methane emissions, given the latter’s outsized effect on global warming. Finally, we were pleased to see the US Securities and Exchange Commission’s (SEC’s) public-comment request for input on climate-related disclosures, and the IFRS Foundation International Sustainability Standards Board’s ambition to establish comprehensive reporting standards by June 2022. Earlier this year, we wrote to the SEC, expressing our support and recommendations for greater climate disclosure regulation. By providing transparency, these steps should enhance investment decision making.
The climate negotiations at COP26 should accelerate a focus on biodiversity and carbon-offset markets. During the past year, our joint research with Woodwell has illustrated the importance of biodiversity loss and the likely underpricing of its possible implications for capital markets. Key definitions and metrics around biodiversity are lacking, so we will look to partner with Woodwell to help develop and integrate these into our investment process. Woodwell has also helped us analyze the role deforestation plays in global warming, and we have jointly created an innovative measure of carbon capture in forestry that may help improve transparency and liquidity in the carbon-offset market.
Climate change remains a primary topic of our corporate engagement efforts. As part of our signatory commitment to NZAMI, we will continue to broaden our stewardship and climate engagement with portfolio companies to encourage adoption of robust transition plans and science-based targets that align with the goals of the Paris Agreement. In our view, transparency (e.g., emissions disclosure) plus ambition (e.g., target setting) are core components of a credible transition plan. Consumers are beginning to demand greater transparency and choices that match their increasingly climate-focused values. We aim to help companies that have not yet disclosed their emissions do so. Once they have disclosed Scopes 1, 2, and 3 emissions, we can better assess the company’s level of transition risk and guide them toward setting targets and integrating those targets into capital allocation and strategic business planning.
These actions will help investors like us better understand potential leaders and laggards in the transition to a lower-carbon economy. In the coming year, we expect that rising pressure from shareholders and regulators will improve transparency around climate-transition risks and potentially lead to pronounced climate-related valuation divergences. As we look ahead to 2022, Wellington will continue to support efforts to improve reporting around climate-related risks and opportunities, while working in partnership with our invested companies on their decarbonization goals. Ultimately, we aim to help companies turn aspiration into action and accountability that are in the best interests of our clients.
1“Adapt Now: A Global Call for Leadership on Climate Resilience,” Global Commission on Adaptation, September 2019.
This is an excerpt from our 2022 Investment Outlook, in which specialists from across our investment platform share insights on the economic and market forces that we expect to influence portfolios in the year to come.
